(Originally published on December 7, 2016, as part of LSE’s Political Risk and Investment Society’s Spotlight Blog)
After two years of market-led oil production, OPEC, in conjunction with some non-OPEC states, has agreed to cut production to raise prices. The two years of market-led output resulted from the organization’s inability to reach an agreement as well as Saudi Arabia’s desire to force the US shale industry into insolvency. After oil prices tumbled to their lowest levels in a decade this past year, the oil cartel saw renewed urgency to set a cap to raise prices.
Overall, OPEC will cut production by 1.2 million barrels a day (b/d), while non-OPEC members, mainly Russia, cut another 600,000 b/d, for a total supply decrease of 2%. Saudi Arabia will reduce its production by almost 500,000 b/d, while most other OPEC members will make smaller reductions. Iran, Nigeria, and Libya successfully campaigned to have minor increases in their oil production sanctioned by the deal, with Iran allowed to increase production by 90,000 b/d. The news of the deal quickly raised oil prices: the price of a barrel of oil rose an average of 17%, between $52 and $56 per barrel on December 1st.
The deal should be taken with a large grain of salt for three reasons: OPEC itself, the US shale industry, and the global economy.
First, the deal is a commitment to reduce output. As with any OPEC deal, continued higher prices are dependent upon members sticking to their quotas, a goal which has been historically ephemeral. Individual producers face the dilemma of cutting production to hold the cartel line, or increasing their own production while others cut, profiting from higher prices while cheating on their own quotas. Yet such cheating ultimately keeps prices lower than they would be if all the producers stuck to their quotas. Past OPEC failures have proven the impossibility of regulating such a dilemma. Russia and Iran are of particular interest. It will be nearly impossible to monitor Russia’s pledge to cut 300,000 b/d because so much of the production moves by pipeline. Iran, a clear winner of the deal, has already framed the agreement in conflictual terms vis-à-vis Saudi Arabia. This conflict, coupled with the uncertain future of the sanctions regime under Trump’s Presidency, may give Iran a high incentive to cheat and produce past its quota.
Second, the US oil and shale industry is still a main competitor. While the deal includes some non-OPEC members, it does not include the US. President-elect Trump has signalled his desire to undue many current regulations slowing US oil production. His advisors are even floating the idea of opening Native reservations to access the estimated 20% of untapped US oil and gas reserves. While this plan is likely to be politically stalled, US production poses another problem for OPEC in the shale industry. Saudi Arabia certainly hurt the US shale industry by increasing production in the last two years, but made critical adjustments to survive. It is now competitive at $50 a barrel, while before 2014 was only competitive at around $70. Increased market efficiency, when coupled with Trump’s plans, nearly ensures that the OPEC deal will simply be a floor preventing the further collapse of oil prices but will not lead to massively increased prices.
Third, the global economy is still sluggish. With anemic growth in the developed West, slowing growth in China and India, the Russian and Brazilian economies suffering from structural and political problems, and no new major rising economies, global demand for oil is low. Much of the higher cost during the last fifteen years was driven by BRIC growth. Without major growing economies to demand oil, prices are unlikely to reach the high peaks they did in previous years.
Taken together, these three factors mean that the OPEC deal, if successfully implemented, will result in only slightly higher prices, likely struggling to break $70 a barrel. Overall, we should not expect much change due to the deal. Instead, we should be on the lookout for countries that cheat on their quotas, as the slightly higher prices may not compensate for decreased sales.